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Although two-tiered annuities provided significant value to those clients who desired safety and were willing to receive their funds over time, they also generated quite a bit of heartburn for insurance companies and agents when clients who misunderstood the design tried to access their funds.

Two-tiered annuities were big sellers in the late 80s and early 90s. The basic concept was that if a client agreed to hold (defer) his or her contract for a minimum of 1 to 5 years and, when he or she was ready to access their funds, was willing to take them as a series of payments (annuitize) for a minimum of 5 to 10 years, the company could afford to pay a bonus of 10 percent or more. The bonus was the “sizzle” that sold the steak.

Essentially, the company kept two sets of books on each annuity. One (the annuitization value) was based on the initial premium plus the bonus compounded at a competitive current interest rate. The other (the surrender value) was the amount available to the client should he or she choose to take settlement as a lump sum. The surrender value was typically 87.5 percent of the initial premium, without the bonus, compounded at a minimum guaranteed rate. The net effect was a policy where the “surrender charge” actually increased over time. The longer you held the annuity, the greater the difference between the annuitization value and surrender value.

Although two-tiered annuities provided significant value to those clients who desired safety and were willing to receive their funds over time, they also generated quite a bit of heartburn for insurance companies and agents when clients who misunderstood the design tried to access their funds. Class action lawsuits against companies like Allianz (the largest distributor of two-tiered annuities) created a bad taste for both clients and agents.

Fast forward to today. The “sizzle” in today’s marketplace is the income rider. Originally designed as a safety net for variable annuities, income riders, or guaranteed minimum withdrawal benefits (GMWBs) have become the main talking point on annuity sales, similar to bonuses of the past.

Just like two-tiered annuities, the insurance company keeps two sets of books. The first is the policy itself. Whether variable, fixed or indexed, the underlying policy must make sense for the client. This is the “cash” account and fully available based on the terms of the policy (free withdrawal, surrender charge, etc.)
The second set of books is based on the rider itself (known as the income base). For example, if the rider offers a 6 percent
compound step-up, this account would reflect the premium plus bonus (if any) compounded at a 6 percent rate.

The income rider also guarantees a specific payout rate in the future. For example, the rate between ages 65 and 69 may be
5.5 percent. When the client chooses to take income, the income will be based on the greater of the cash account or the income base. Let’s take an example:

If the client above is now at age 65, he could take income of $7,419 (assuming a 5.5 percent payout rate) for the rest of his life.
Each withdrawal would be deducted from his cash account while it continued to work. If, based on the account’s performance and the withdrawals, the cash account went to zero, the insurance company would continue to make payments of $7,419 annually until the death of the client. If the cash grows to a larger number than the income base (which is what you would hope), income
is based on that number. The concept is fairly simple.

Now, let’s complicate the process. Interest rates drop, the market (S&P 500) is volatile. The “steak” is harder to sell.
Now everybody is talking about income riders. We had a variable annuity wholesaler visit our office last week and not once did he mention the contract itself or the sub-accounts offered. The entire discussion was about their new, improved income rider.
Don’t get me wrong, but it’s a little like planning the cruise of a lifetime and spending all your time examining the lifeboats.
Let’s not lose sight of the fact that an income rider is just that — a lifeboat — only to be used if the ship itself doesn’t perform as anticipated.

Consider this. In the above example, if the client took the same $100,000 and buried it in a shoebox in his backyard for five years and then used it to purchase a single premium immediate annuity at age 65, he would receive about $7,692 per year — almost $300 per year more than the new and improved income rider. The moral of the story: Beware of the shiny object.

Now that we have some perspective, what are some of the “gotchas” with these riders?

Simple vs. compound interest — A prime contender of the “beware of shiny object” award. Isn’t 8 percent bigger
than 7 percent? Not if we are talking about simple versus compound interest. If you invest $100,000 and earn 8 percent simple interest, your value at the end of 10 years is $180,000 — that’s a 6.05 percent return. A 7 percent compound rate would yield $192,715 at the end of 10 years.

Low payout in income years — This is the classic two-tier scenario. If a company sells the “shiny object” of a high step-up, it can capture the money and only give it back as a series of payments over someone’s lifetime at a much lower interest rate. The client can always claim the surrender value as a lump sum which may be significantly lower than the income base.

Poor underlying performance — The moving parts in index annuities can be complex. Often, companies will balance the “shiny object” with a combination of hidden factors. Remember the water balloon analogy? In order to make it pop out in one area, you have to squeeze somewhere else. Consider this: When can a 4.25 percent cap exceed a 7 percent step-up? Never. So, if you are lucky enough to cap out every year, you have one set of books growing at 4.25 percent and another growing at
7 percent. The “big” number must be taken as a series of payments during your remaining lifetime. Sounds like a two-tiered annuity to me.

Fees that invade principal — If you are selling an index annuity and telling a client their account can never lose money, then how do you explain the fact that fees charged by an income rider can actually result in a lower year-over-year value in a down market? As far as I’m aware, there is only one policy on the market that only deducts fees to the extent there is gain.

Fees charged against income base rather than accumulation value — This is one of the areas where companies will “squeeze the
balloon.” Let’s assume the index performs poorly or stays flat. If the company charges a 0.80 percent fee against the increasing income base, every year, a larger and larger deduction is made against the cash account, creating a downward spiral on a supposedly guaranteed asset.

Non RMD or free withdrawal friendly — Harry retires from his job at age 55 and rolls over his $500,000 401(k) to your indexed annuity. He plans on consulting for the next 10 years until he is 65, then taking income. At 52, he has an emergency and, understanding the tax consequences, takes a 10 percent free withdrawal. He turns on the income switch at age 65 only to find that his payout percentage was locked in at age 52 due to the withdrawal. Is your E&O paid up?

These are just some of the features to consider if you are using an income rider. With these challenges in mind, we’ve begun
using the total benefits of ownership (TBO) concept. This works particularly well with policies offered by The Annexus Group using the Family Endowment Rider which offers a 4 percent death benefit step-up. When used in combination with an income rider, we can cover all four areas of concern for most clients: protection, accumulation, distribution and wealth transfer. When you add up the total value a well-crafted policy can provide, the total benefits of ownership are apparent.

In a recent study (Financial Planning Magazine – March 2011) it was found that “advisors have a history of being significantly disconnected from their clients’ actual needs.”When clients were asked what their top concern was, 86.6 percent said, “losing their wealth.” When advisors were asked the same question, only 15.4 percent believed “losing their wealth” was the most important.

About the Author

Jason A. Kestler, President, CEO of Kestler Financial Group, Inc. has been working in the financial services industry since 1997. Using innovation and determination in his marketing efforts, Jason’s goal is to build the organization every day, ensuring a long and prosperous future for KFG and... More